Follow Uncle Sam: Get Out of Debt

The U.S. Treasury is finally beginning to pay down its debt. We all should take the hint.

It’s not just that the Federal Reserve raised interest rates Wednesday, a move that will increase the costs of most consumer loans, from credit cards to home equity credit lines.

Debt was already getting more expensive, thanks to previous Fed moves and other market pressures. And family indebtedness seems to be increasing. What this means is that many families are moving closer to the financial edge, perhaps without even knowing it.

The Fed is trying to make credit more costly so that consumers and businesses will think twice about spending. Raising interest rates has been a powerful tool in the Fed’s war to contain inflation, which can be fueled by consumer and business spending--in essence, by people throwing money around.

And it seems we have been doing so, with abandon. From 1995 to 1998, median family indebtedness grew sharply from $23,400 to $33,300--a 42% increase, according to a Fed study on consumer finances released last month. The figure includes all forms of debt, such as mortgages, credit cards and car loans.

Many families aren’t in trouble yet, because the growth in our assets--home values, stock holdings, bank accounts--has grown even faster. So despite the increase in debt, net worth--total assets minus total debt--grew about 18%, to $71,600.

Still, real estate and the stock market have the nasty habit of losing value from time to time. Just ask anyone who invested in stocks in the early 1970s, or who owned a home in Southern California during much of the 1990s.

How many people who today are charging their credit cards up to the limit or are borrowing against their home equity would be confident they could pay their bills if they were abruptly laid off? How many have set aside an emergency fund equal to three months’ expenses--generally the minimum recommended by financial planners?

The Fed data tell us that many people are already pushing their luck. The Fed estimated that one family in eight spent more than 40% of its income to pay debt in 1998; consumer credit counselors generally warn against paying more than 35% of income for all debt, including mortgages, and say payments on consumer debt such as auto loans and credit cards should not exceed 20% of income.

There are probably millions more households whose debt levels are lower but who are still dangling over a financial precipice--families with few assets who aren’t saving enough for retirement or putting aside money for the kids’ college education, who are living paycheck to paycheck with the idea that they’ll start living within their means at some undefined period in the future. Meanwhile, the interest these people pay on their debt continues to get more expensive.

Take credit cards. Most credit card rates are tied to the prime, a benchmark rate that quickly reflects Fed moves. In addition, credit card companies have become quicker to jack up rates if a payment is late or if a check of the cardholder’s credit record shows too many new credit lines or a late payment on other debt.

The prevalence of such punitive rates has more than outweighed the beneficial effect of all those low 3.9% teaser rates, said Robert McKinley, president of CardWeb, a credit card research firm.

The average interest rate people pay on their credit cards has been creeping higher in recent months and stands at nearly 18%, up from 16.4% four years ago.

So what should a consumer do? Here are some ideas:

Explore alternatives. Mortgage hunters can make larger down payments or agree to automatic electronic payments to get slightly lower interest rates, for example. Lower rates are also available on 15-year mortgages and on hybrid loans that are fixed for three to 10 years before becoming adjustable.

Lock in rates. If you fear rates will climb higher, opt for fixed rather than adjustable rates. Home equity loans, which have fixed rates, cost about three-quarters of a percentage point more right now than home equity lines of credit. But getting a home equity loan at today’s rate means your payments won’t go up if rates should rise in the future. If rates fall, you can always refinance at a lower rate.

Finding a fixed rate on a credit card can be tougher. Card issuers tend to have higher credit standards for fixed-rate cards, and “fixed” can be a misnomer because issuers can change their terms with just 15 days notice. But if you have good credit, you should look for a low fixed-rate offer.

Avoid new debt. No one really knows what will happen to interest rates in the future. But it makes sense not to add to your debt, especially if your payments are already chewing up more than 35% or so of your salary, or if you’re worried that a job loss or other financial setback could be in your future.

If your debts are already high and you’re having trouble paying your bills, consider getting help from a nonprofit credit counselor such as Consumer Credit Counseling Service of Los Angeles (https://www.cccsla.org).

Break into the piggy bank. It makes little sense to carry credit card debt at 17% if you have cash in a money market account earning 5% or in a savings account earning 2%. Paying off the debt is the equivalent of getting an absolutely safe, guaranteed 17% return. (The only higher guaranteed return you’ll get is from funding your 401[k] to get the full company match--every dollar contributed gets a 50% return if your company matches at a 50% rate. So don’t reduce your 401[k] contributions to pay off your debt.)

This raid-the-bank advice may directly contradict the notion that people should have at least three months’ expenses saved as an emergency fund. Here’s why: If you lose your job, you can always rack up the credit cards again. Meantime, you’ve saved big bucks on interest costs.

Some folks don’t feel comfortable with an empty savings account, however. For those people, keeping a month’s worth of expenses may give them enough of a comfort zone to apply the rest toward their debt.

People who have investments outside their retirement accounts might also think about cashing in some of them to pay off debt. Few observers believe the stock market can keep up its pace of dizzying returns; the better part of valor may be taking some profits now to pay down nondeductible debt. (It rarely makes sense to tap retirement accounts to pay off debt, however, because of the loss of tax-deferred returns over time.)

Speed up payments. The more quickly you are out of debt, the less vulnerable you are to interest rate increases. Larger payments also sharply trim the amount of money you spend on interest costs. As noted here last week, it would take more than 40 years to pay off a $5,000 credit card debt if you made only minimum payments.

Liz Pulliam Weston can be reached at liz.pulliam@latimes.com.

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Family Debt, Assets Grow

Median family indebtedness grew by 42% between 1995 and 1998, according to a Federal Reserve survey of consumer finances. But net worth has increased because the growth in debt was outstripped by the growth in family assets, which include bank accounts, stock market holdings and real estate.